Vol. 4 - Minimizing Insurance Risk Transfer Costs

THE NEXT STEP IN LDI EVOLUTION

As corporate defined benefit plans increasingly have shifted their focus to portfolio de-risking, many have sought fixed income benchmarks that are better aligned with the specific objectives they hope to achieve through liability-driven investing (LDI).

Some sponsors have shifted to longer-duration measures, such as the Barclays Long Credit Index or Barclays Long Government/Credit Index, while others have adopted compound benchmarks or duration-targeted indexes. 

T. Rowe Price believes an even higher level of customization is both necessary and feasible. Accordingly, we have developed a methodology for constructing custom fixed income benchmarks at the most granular level possible—the individual cash flows, both principal and coupon, derived from a given fixed income opportunity set. 

Based on the bonds in the relevant opportunity set, we create a benchmark that matches, as precisely as possible, a plan’s projected liability cash flows. To ensure continuous liability matching, this investible benchmark is then reset each year to reflect the plan’s actuarial experience, new pension cash flow accruals, and bond market developments.¹

SPONSOR OBJECTIVE: MINIMIZE THE VOLATILITY AND OVERALL LEVEL OF INSURANCE RISK TRANSFER COSTS

To highlight the potential benefits of T. Rowe Price’s LDI customization process, we have created a benchmark for the hypothetical plan liability structure shown in Figure 1 (below, right). We assume the sponsor’s LDI objective is to minimize the volatility and overall level of insurance risk transfer costs, which a has two components: reducing portfolio tracking error relative to liabilities and ensuring the portfolio is attractive to insurance companies, allowing an in-kind asset transfer. In our view, creating a benchmark that reflects these considerations might be appropriate for plan sponsors who are considering:

• terminating the entire plan within some defined period,
• transferring a portion of the plan’s liabilities to an insurance company via a group annuity contract (buyout),
• purchasing annuity coverage that matches some segment of the plan’s liabilities (buy-in).

Given the insurance company preferences for in-kind asset transfers, the most appropriate opportunity set for such an investor would be a fixed rate Gov/Corporate universe consisting of U.S. Treasury obligations as well as investment grade (IG) corporate bonds. This universe has a sufficiently high average quality relative to insurer  discount rates and satisfies insurance companies’ preferences for in-kind transfers.  Based on our conversations with insurance companies, sponsors who prepare their portfolios for an in-kind transfer receive better overall pricing because the insurer doesn’t incur transactional costs on the deal.

The sponsor’s strategic objective would be to minimize portfolio tracking error relative to the benchmark—and thus to the returns on the liability as measured by insurance companies. Our hypothetical custom benchmark (Figure 1B) is designed to provide a much more precise match of the liability structure than would be possible using a standard market-weighted index, such as the Barclays Long Credit Index (Figure 1A). The 10 largest non-Treasury issues in the custom benchmark are shown in Figure 2. Because Treasuries are highly liquid and present minimal default risk, taking large positions in specific issues does not raise the same concentration concerns as it would in an investment grade corporate issue.

Appendix: Constructing Custom LDI Benchmarks

T. Rowe Price has developed its own custom LDI benchmark methodology, which we believe has the potential to:

• reduce liability tracking error compared with market cap-weighted benchmarks and composites,
• allow managers to tailor their investment process more closely to sponsor objectives in terms of spread, duration, and curve sensitivities,
• demonstrate their performance relative to plan liabilities more precisely.

STEP ONE: DEFINE THE OPPORTUNITY SET BASED ON THE SPONSOR'S LDI OBJECTIVES

Hedging asset performance should be monitored as closely as possible against the liability measurement most meaningful to the sponsor. Because different regulatory and accounting regimes use different discount rates, the optimal opportunity set will depend on the sponsor’s de-risking priorities.

STEP TWO: CONSTRUCT A YIELD CURVE

Once the relevant fixed income opportunity set has been defined, bonds are broken down into their discrete coupon and maturity cash flows. In essence, this procedure treats every cash flow as if it were a separate zero-coupon bond, then uses those flows to construct a zero-coupon yield curve that can be matched against the plan’s cash flows.

STEP THREE: ESTIMATE THE PRESENT VALUE OF LIABILITIES

Discounting plan cash flows using the model curve provides the yields needed to determine the plan’s interest rate sensitivity at each point on the curve. The curve is stressed by incrementally increasing and decreasing the yields at each point in order to determine key rate durations (KRD).

STEP FOUR: OPTIMIZE THE BENCHMARK

Asset cash flows are matched to liability KRDs, taking into account how much impact each point on the curve has on the overall present value of plan liabilities. The result is a customized benchmark in which asset and liability weights are matched relatively precisely, especially in the most interest rate sensitive portion of the curve.

With the structure in place, the mandate to the asset manager becomes relatively straightforward: either replicate or outperform the liability-matching cash flow benchmark, while also matching spread and curve sensitivities as closely as possible using instruments that are actively traded and have a reasonable degree of market liquidity.